A Look At Gibson's Paradox And Gold
Commodities / Gold and Silver 2010 Jun 23, 2010 - 01:32 AM GMTBy: Jim_Richter
As I write these words in late June, 2010, I note that gold went to an all-time nominal high against the dollar on June 21. However, even though we find ourselves in the worst financial crisis since the 1930s, gold has still not reached a REAL, inflation-adjusted high. Using the numbers given to us by the U.S. government, gold would have to reach a nominal price of about $2,400.00 per ounce to equal its January, 1980, high of about $850 per ounce. Other analysts, such as the noted John Williams, of Shadow Stats, contend that gold would have to reach a nominal high of about $7,595.31 per ounce in order to equal its 1980 high in real terms. Suffice it to say that there are some who think that gold should be a lot higher in price than it is at present.
In March, 2010, there were some fireworks at the CFTC hearings when Bill Murphy, President of GATA, revealed evidence of metals market manipulation which had been provided to him by Andrew Maguire, a London precious metals trader. Murphy's revelations set off an angry debate between those who believe that the gold and silver markets are highly manipulated and those who do not. I wrote an article in my newsletter about the CFTC revelations. I even got a few "nastygrams" after posting my article. Gold engenders strong feelings!
During the CFTC brouhaha, Jim Puplava, of the excellent Financial Sense website, hosted a debate between Mr. Murphy and Jeff Christian, of the CPM Group. During that debate, Mr. Christian argued against the manipulation theory. He even asserted that central banks think very little about gold. I will admit that I was surprised that he would say this. Quite frankly, central banks think a LOT about gold. In fact, after being net sellers of gold for many years, they have become net BUYERS of gold during recent months. Why would they BUY gold and store it in vaults if they did not think about it? Indeed, why would they own it at all?
It is not my purpose to re-kindle the hot tempers which erupted after the CFTC hearings. However, we do live in a world where all currencies are FIAT currencies. For this reason, I think that it is helpful to re-examine some of the reasons WHY a central bank might want to manipulate the price of gold. With that in mind, here are some pertinent parts of an article I wrote in October, 2008, in the aftermath of the Lehman Brothers collapse:
I write this newsletter in a non-academic style because I do not want my readers' eyes to glaze over after a minute's-worth of reading! Academic economic writers dress up economic concepts in "high-fallutin" language. The reader's mind shuts down. That which is simple is rendered impossible to understand! No wonder so many people think that economists are practitioners of some kind of occult art!
Having issued the foregoing disclaimer, I believe that the time has come to discuss a VERY academic concept, Gibson's Paradox. Much of what has happened with the gold price since the mid-1990s is only explicable if one has a basic understanding of Gibson's Paradox. When one does understand it, one immediately sees why governments and central banks will do everything in their power to suppress the price of gold, as has happened since about 1995.
In the 19th and early 20th centuries, conventional economists believed that long-term interest rates were correlated with the rate of change in the general level of prices. However, in 1923, A.H. Gibson, an English economics writer, published an article in a British magazine wherein he asserted that the rate of interest and the general level of prices were correlated. In other words, the correlation was between interest rates and prices, rather than the rate of change in prices. Gibson produced 131 years' worth of statistics which backed up his assertions.
Gibson argued that the prices of British government bonds depended upon the long-term interest rate, and that this, in turn, was determined by the level of wholesale prices. When interest rates are low, then investors will find it attractive to invest in equities (because they will deliver better yields). Investments in equities will, in turn, lower the costs of production. This will be reflected in lower consumer prices. It should also be remembered that when long-term interest rates are lower, the prices of long-term bonds are higher.
Gibson's article came to prominence because John Maynard Keynes happened to read it. The article's main thrust had been with regard to stock and bond investing. Keynes was an avid stock market investor, and he had previously believed that long-term interest rates were correlated with the rate of change in general price levels. Gibson's work caused Keynes to revise his thinking. It was Keynes who invented the term "Gibson's Paradox."
But what does Gibson's Paradox have to do with gold? EVERYTHING! In 1988, two young economists wrote a paper entitled, "Gibson's Paradox and the Gold Standard." One of the economists was Lawrence Summers, better known as the man who succeeded Robert Rubin as Secretary of the Treasury during the Clinton administration [and the man who is now President Obama's top financial advisor]. The paper is a very "dry," academically-oriented one. However, the main idea proposed in it is this: Higher real interest rates mean lower gold prices, and vice versa.
Here is what Mr. Summers and his co-author, Robert Barsky concluded: "The price level under the gold standard behaved in a fashion very similar to the way the reciprocal of the relative price of gold evolves today. Data from recent years indicate that changes in long-term real interest rates are indeed associated with movements in the relative price of gold in the opposite direction and that this effect is a dominant feature of gold price fluctuations." In summary, gold prices and REAL INTEREST RATES move in opposite directions in a free market.
As a practical matter, what does this mean? It's simple, yet complicated. As I have stated many times in this newsletter, gold is money, no matter what Keynesian economists might say. Gold is the proverbial canary in the coal mine. It tells us when something is rotten in the world of fiat currency. In a free market, if gold prices are rising, it tells us that REAL INTEREST RATES are too low. However, if interest rates rise, bond prices will fall. There will be less of an incentive for stock market investment because real interest rates will be yielding better returns for investors.
Clearly, the perfect world for a central banker would be one in which the stock market is flourishing. However, the BIGGEST market is the bond market, so it is the most important market for the central bankers. Keep interest rates low, and all your owners (JP Morgan Chase, Goldman Sachs, and the other banks) can make BILLIONS! The real estate market will go ballistic. Indeed, you have the best scenario, except for one thing: In a free (i.e., UNMANIPULATED) market, the gold price moves inversely to real interest rates. If you keep interest rates artificially low, gold will go up in price. When gold goes up in price, the dollar is worth LESS relative to gold. The dollar is thus revealed as a shabby, counterfeit piece of Crane Company stationery with ink on it. It follows that it might be helpful if the gold price could be suppressed.
Reginald Howe has contributed many scholarly articles to the Gold Anti-Trust Action Committee (GATA). Mr. Howe publishes occasional commentaries at his own website, www.goldensextant.com. Mr. Howe has proven beyond ANY DOUBT that, in 1995, real long-term interest rates and gold prices "began a period of sharp and increasing divergence..." When Mr. Howe wrote those words in 2001, real interest rates had declined from 4% to about 2%. Under Gibson's Paradox, and according to Summers and Barsky, when real interest rates declined, the price of gold (in dollars) should have gone up. Instead, Reg Howe pointed out that the gold price had fallen from about $400 per ounce to around $270 per ounce. When he wrote his article, Howe calculated that, had the markets been left to operate freely, then gold should have been priced at about $500 per ounce. However, the opposite had happened. Instead of rising in price as real interest rates fell, gold had also fallen. Why?
Do you remember the "Strong Dollar Policy," as enunciated by President Clinton's Treasury Secretary, Robert Rubin? It turns out that this was nothing more than a scheme by which to have the best of all possible worlds: Stock market? UP! Interest rates? DOWN! Bond prices? UP! Dollar? UP! Gold? DOWN! How was this accomplished?
It is not the purpose of this article to enumerate all of the ways in which the U.S. government, other central banks, as well as their allies in the private sector (JP Morgan Chase, Goldman Sachs and others) colluded in order to suppress the price of gold so that they could accomplish their other objectives. For the full story, go to www.gata.org and read all about it. However, here are some of the things which were done:
1) Central banks sold their actual gold reserves into the market, thus flooding it with extra supply and depressing the price. Prime Minister Gordon Brown did this during the late 1990s when he was Chancellor of the Exchequer. He sold a very significant portion of Britain's gold at an average price of less than $300 per ounce. Gold is now priced at more than $800 per ounce. What a GREAT DEAL for Britain! [Editor's note: It's an even better deal now!] Western central banks are STILL selling their gold under an agreement which began in 1999 and was extended in 2004, although the current financial crisis seems to be diminishing some of the banks' enthusiasm for continued gold sales. Germany has even announced that it does NOT want to sell more gold. [Editor's note: I wrote this article in October, 2008. The financial crisis did diminish the banks' enthusiasm for selling their gold. They are now net BUYERS!]
2) Central banks have leased gold into the markets, thus creating an artificial "oversupply" of gold at a time when overall mine production of gold has been on the decline. This has also depressed the gold price. How does this work? The Fed allows JP Morgan Chase, Goldman Sachs, or other "bullion banks" to lease gold at ridiculously low interest rates (usually LESS THAN 1%). The bullion banks can then SELL the gold and take the proceeds to invest them into other things yielding a higher rate of return. The bullion banks will make risk free profits as long as the price of gold stays about where it was when they "borrowed" it. However if the gold price rises too much, the bullion banks can lose money because they will essentially be caught in a short-covering squeeze. Bullion banks have made BILLIONS in profits by "borrowing" OUR NATIONAL TREASURE and selling it! We do not know whether or not the Fed (or other central banks) will ever make the bullion banks "cover." The federal government has "stonewalled" against all efforts to find out how much gold the United States actually has.
We are in an environment in which our government and our central bank, the Fed, have kept real interest rates artificially low. This has been going on since the Greenspan era. Remember when the Greenspan Fed dropped rates to 1%? Yes, lowering interest rates ignited the stock market in the 1990s. We also got an epic bull market in bonds. By suppressing the gold price, we got a "Strong Dollar." However, we got some other things as well. We got serial speculative bubbles which inflated and then collapsed. The dotcom and real estate bubbles each vaporized TRILLIONS of dollars of wealth. We also got malinvestment, as artificially low interest rates conveyed a FALSE picture of the economy to businesses and to ordinary investors.
In a truly free market, when one aspect of the economy gets out of balance, the natural forces of the market act in such a way as to bring things back into balance. In a free and natural market, the government's artificial lowering of interest rates would have triggered a RISE in the gold price. This would have exposed the shabby house of cards which our fiat financial system has become. Instead, our leaders chose to continue to manipulate the markets, and we are now paying the price because we are in the worst financial crisis since the 1930s. Based upon the events of September, 2008, I now believe that this crisis is going to be WORSE than the 1930s. That was a deflationary depression. This is going to be a hyperinflationary depression. [Editor's note: I still believe that we could see hyperinflation at some point, especially if, in desperation, "Helicopter Ben" Bernanke cranks up the proverbial printing presses in an attempt to inflate his way out of the current situation. However, recent deflationary forces have also caused me to moderate my "inflationist" views. If the current trend of credit contraction continues, we may get a deflationary collapse.]
Given recent events, I believe that our government is now trapped. If it wishes to avoid a deflationary collapse, it must inflate as never before. The Fed will have to LOWER interest rates. We can expect the war against gold to continue. Even this year [2008], several bullion banks took record short positions against gold on the COMEX. The US dollar had a "Hail Mary" rally! However, given the absolutely DISMAL fundamentals for our economy, these kinds of attacks are akin to an army which executes a fighting retreat. The army wins some battles, but the overall direction is retreat. Since 2000, gold has gone from about $250 per ounce to about $880 per ounce as I am writing these words. This has occurred in spite of all the manipulation. Had the gold price not been manipulated, it would be MUCH HIGHER. It will get there!
A Postscript:
In October, 2008, the gold price was at about $880 per ounce. In June, 2010, the gold price hit an all-time nominal high of $1,265.07. Despite the efforts of central banks and bullion banks, the gold price has gone up steadily since 2000. In that respect, I am reminded of one of the key tenets of the Dow Theory: You might be able to manipulate the day-to-day trend. You might even be able to briefly influence the medium-term trend. However, you cannot manipulate the long term trend.
The Fed's interest rates have remained at 0% for an extended period of time. Please remember that, under Gibson's Paradox, in a free market, the gold price moves INVERSELY to real interest rates. Real interest rates are currently NEGATIVE. That, above all else, is the reason why central banks might actually think about gold from time to time! It's also a reason why they might even want to try to suppress the price!
A Few Quotations:
"I can't remember the exact quote but when I used to trade and Mr. Volcker was Fed chairman, he said something like 'gold is my enemy, I'm always watching what gold is doing', we need to think why he made a statement like that. If you're a central banker or one of the congressmen or senators, watch what gold is doing because this is a no-confidence vote in fiscal and dollar policy."
Rick Santelli, CNBC
"You mean to tell me that the success of the economic program and my re-election hinges on the Federal Reserve and a bunch of f***ing bond traders?"
William J Clinton, President of the United States
"There are no more markets anymore, just interventions."
Chris Powell, Secretary/Treasurer. GATA
(This article was originally published in a prior issue of The Richter Report. It has been updated and made accessible to the public. Please feel free to visit the website and look around. There's a lot more for paid subscribers.)
By Jim Richter
© 2010 Copyright Jim Richter - All Rights Reserved
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